Hard money lender sounds like a scary term. It sounds like a bogeyman that politicians like Elizabeth Warren and Bernie Sanders would want to target for annihilation. The truth is, hard money lenders serve an important function and should not be looked at like “predatory” lenders like credit card companies or paycheck advance stores. They serve an important function for the borrower and they allow the borrower, the lender and any of its investors to all realize healthy returns. The fact that hard money lenders exist demonstrates more than anything how screwed up the residential real estate financing market can be.
Hard money loans in the residential real estate market are generally only made to investors who plan on only using the loan for a short period of time before they either sell the property or refinance into a permanent loan. They are used because the borrower is able to either purchase the property at a discount to its market value (at a trustee sale, for instance) or the property has flaws that when corrected will result in the property being worth far more than the investor paid (a fixer-upper). Many times both will apply (bargain purchase and fix-up potential). The investor would obviously prefer to use a conventional mortgage at a very low interest rate, however, it is not available for a few reasons. The main reason is that banks don’t close loans fast enough. Trustee sales generally require the property to be paid for the same day it is bid upon or the next day. Banks often take 30 days. There are 4 or 5 other reasons that bank loans aren’t available. Banks require a title policy; investors can complete the title research to know they are buying a first mortgage without other liens, but usually can’t get a title policy fast enough. Banks require an appraisal and again, that can’t get completed fast enough. Banks don’t want to make a loan that is likely to be refinanced or paid off 6 months later. Banks often cap the number of investment loans they will make to an investor; an investor can use hard money lending to invest in more properties at once.
The 5 Biggest Myths about Hard Money Lenders
Hard money lending is one of the most misunderstood aspects of residential real estate finance. Here are some of the bigger myths:
- Hard Money Loans are loans of last resort. Someone taking out a hard money loan is not living paycheck-to-paycheck and they need something to hold them over for a few days so they can pay their rent. While hard money loans may be the only lending option for the borrower, they do have a good backup option which is to walk away from the deal. The only thing they will suffer is the loss of opportunity; they will not end up on the street or be leveraged up to the eyeballs in debt.
- Hard Money Loans are the last step before someone gets foreclosed on. Hard money lenders don’t generally make loans to homeowners; most will only make a loan to an LLC or a corporation. They don’t want to lend against an owner-occupied house. They do not want to foreclose on properties. They want to get their loan paid back so that they can turn around and loan those funds to the exact same borrower again on their next investment. They often charge points up front so that they have more incentive to originate new loans.
- Hard Money Loans allow you to purchase a home with No Money Down. Why would a hard money lender allow this? They would take all the risk and the investor would potentially get all the gain while risking nothing (no skin in the game.) Hard money lenders often require something close to 65% loan-to-value (LTV). They certainly will not touch loans that are routinely made by conventional and FHA lenders at 90-97% LTV.
- Hard Money Loans allow you to buy a property and improve your credit before you refinance. Again, most hard money lenders don’t loan to owner-occupants. Buying with a hard money loan with hopes that you could improve your credit and refinance in a couple of years would be a crazy strategy that would not work well. The interest rate and fees would be very high and would not even begin to make any sense unless the property had extreme appreciation of 20-30% each year. Some hard money lenders may not report to the credit reporting agencies so you would not receive the benefit of that. If the hard money lender found out you were living in the property, they might be able to call the note.
- Hard Money Loans aren’t underwritten as tightly as conventional loans. Hard money loans may be underwritten differently, but they definitely do their due diligence to prevent losing money on the deal. They are going to pay much more attention to the property itself vs. paperwork minutiae like that can delay a conventional loan. Hard money loans are asset-based so they care much more about the collateral. Most hard money lenders are extremely knowledgeable about a particular market and often actual walk the property themselves before approving a loan. They have a much more manageable volume and much larger percentage of their own capital invested in each deal compared to a mega bank. Hard money lenders are generally much smarter when it comes to local real estate than the various mortgage people involved in a loan that may be several states away.